How To Avoid Costly Surprises In A Real Estate Investment

Most people are, somewhat, familiar with how real estate investing works and have some sort of investment in a real estate property or a deal. To many people investing in real estate can be a daunting experience and can come across very risky which would turn them away from investing in a real estate opportunity.

I’m not going to sugar-coat it and tell you that investing in real estate has no risk at all. Just like any other investment there’s a level of risk that’s associated with RE investments. As the definition suggests, goal of an investment is to return a favorable result/gain over a period of time, but doesn’t necessarily guarantee a risk-free opportunity.

Let’s face it as investors we’re sending our HARD EARNED money out to grow and have the expectation that it comes back even bigger. It’s no different in Real Estate - name of the game is capital preservation and capital growth.

What’s really important to know is that even though risks are an inherent part of any real estate investment, it shouldn’t be the reason why you don’t invest in real estate at all.

What I’ve learned over the years is those who are good at managing risk are those who will continue to see success in whatever endeavors they undertake. In simple terms, you need to be able to look far enough ahead to:

1. Identify Risks

2. Mitigate Risks

3. Manage Risks

As part of any investor you need to know as many of the unknowns (risks) as possible and know that the team that’s managing the investment is a good fit when it comes to actively addressing those risks.

Let’s break it down

I have always been a fan of simplifying things to make myself understand the concepts easier - In the case of a real estate syndication, I like putting things in two simple buckets of WHO and WHAT. Obviously, the Who is the team that’s managing the asset and the What is the asset itself.

The WHO

In every transaction, investors are trusting the operators of the asset to make the best decisions for the asset and, in turn, return the best possible profits to the investor. In order to deal with some costly headaches in the future any investor would benefit from asking a few questions to ensure they’re more comfortable with the fact that their money is in good hands.

So what should you ask them?

Experience

Asking the sponsor about their track record and experience is one of the first items on every investor’s list. You’ll need to look at their track record and know how they’ve done in the past with a similar type of property.

One of main points that needs to be explored is how the operators will deal with potential risks associated with the deal. You’ll need to know that they’re going to be proactive about identifying risk and knowing how they’ll mitigate some of the known risks associated with the property.

"An Investment in knowledge pays the best interest"

Surely we can’t know EVERYTHING about the property and the things that can go wrong, but the idea is that you’ll want to know that the person(s) that’s going to be making decisions has the right person for the job.

Ask them about a previous challenging experience and/or a deal - how did they deal with the issue? What was the outcome?

Experience shouldn’t stop at one or two persons - all members of the team should be known and their track record should be readily available for review to all. This includes those involved with property management, legal team, CPA’s, etc. What you’re looking for is the depth of the team that’s going to be managing the asset.

Don’t be shy….. Always ask for references and CALL THEM. After all, you’re giving them a lot of your HARD EARNED money to manage.

Expectation

One of the things that should be clarified as part of the deal presentation is how the property will perform given certain conditions. For example, you’ll want to know the property performance (NOI) should there be a 20% vacancy or other negative impacts to income for the property. Find out what the break-even point is for the property - how much do you need the monthly income to be to be able to pay all expenses. All simple questions that can be ask to ensure the investment is in good hands.

Again, we’re not trying to figure out every single situation, but want to do some scenario analysis to ensure we’re aware of the property performance given certain situations.

Another red flag that investors want to look out for is syndicators that are over confident in the property’s performance. I’ve seen some syndicators advertising the property based on their BEST CASE scenario and not being realistic as to what can actually happen once the property is under management. Best case scenario is great only if all stars align and no risk is realized during operation of the property.

WHAT IF’s

Now onto some of the items most don’t usually think about or really focus on. We’re not all experts in reading the Operating Agreements and/or the Private Placement Memorandom’s (PPM), but it’s VERY important that every investor thoroughly review the investment documents and ask questions.

One of the items that I consider risk mitigation is how conflicts will be resolved while the partnership is in place for the investment. You’ll want to know the structure of the partnership as well as the details of each partner and their roles and responsibilities associated with the partnership and the investment. As part of the agreement you’ll want to know the voting rights of the members including both General Partners as well as the Limited Partners.

The WHAT

What are some questions you should ask about the property to ensure you’re increasing your comfort level with the property? Certainly, questions are endless and you can find yourself going down many many rabbit holes and not being satisfied. Let’s cover a few key items that would help paint a better picture of how “risky” the investment is.

What kind of property are you getting into?

Two of the most important things you’ll want to know is what type of property you’re dealing with and where is the property located? Both very important questions that need to stand out as part of the offering memorandum.

What you’ll want to know is that the business plan clearly states the asset class and defines what the future plans are for the asset. By knowing the asset class you’ll be able to better understand some of the risks associated with the property and the potential issues that can arise.

As important as the asset class is it’s equally important to know WHERE the property is located. Not only do we need to know the actual market it’s in, but also need to take a deeper dive into the submarket the property is in. Again, the business plan should have a comprehensive look into the property’s whereabouts and the reasons why the syndictor has chosen the specific market.

One of the things that may not jump out at an investor is whether the property is in a crime-riddled (war zone) neighborhood even though all data for the market point towards having a strong performance in the future. Again, not necessarily a bad thing if you have the appetite for additional risks and also know that the operator has experience in such markets.

Show me the money

Let’s not forget about the financial performance of the property. Bottom line is that investors are going to be looking for their Return On Investment once all the dust settles.

As an investor, you’ll want to be clear as to what you’re looking for in a deal. Are you looking for a yield play or a significant gain on your initial investment via heavy value add. It’s not advisable to dive into a specific deal until the investor is clear about their investment goals as well as their risk tolerance.

Once you’re ready to get into the numbers, a few key metrics can be beneficial to understand as a starting point.

What’s the purchase price and associated CAP rate? One of the things that you can look into is whether the purchase CAP rate is realistic given the market and the specific property. Going back to setting realistic expectations, we’ll want to know that the beginning point (purchase price) is either in alignment or beats the market data.

What is the expected rate of return? This can be in the form of Cash on Cash, IRR, AAR, Equity Multiple, etc. There’s no shortage of investment return criteria that you can look into, but you’ll need to make sure the returns align with your investment criteria and that the numbers are realistic given the property and its associated market.

Another important factor that investors need to look at is how long the investment will be held for and what the exit strategy is. Since the investment is fairly illiquid for the duration of the investment, you’ll want to know how long your money is being held. Some multifamily investments provide a refinance after a few year in order to pay back some (or all) the initial investments. This should be clearly defined as part of the business plan including the timeline and potential rates.

You also want to make sure you pay close attention to the fees that are being paid to the sponsors.

What else?

Finding the right investor and the right investment is not exact science. A lot of attention needs to be paid to details to ensure the investment is the right fit.

Yes, there’s risk associated with the investment, but NO it doesn’t have to mean that you shy away from investing in a real estate investment deal.

One of the ways that one can reduce associated risk is to educate themselves to ensure they’re aware of all aspects of a syndication. There are many free tools and resources out there for investor to take advantage of. Some of them include:

• Listen to Real Estate Podcasts

• Read books related to Real Estate

• Read blogs such as this one

• Visit educational websites such as www.Biggerpockets.com

• Connect with other investor and syndicators on social media

• Join local meetups (now also offered virtual)

As always we’re here to help walk you through any questions you have. If you’re interested in joining our club please be sure to subscribe below.

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Sam Khairi | Afto Capital